How to Make Finance Work

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Executive Summary

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Once a sleepy old boys’ club, the U.S. financial sector is now a dynamic and growing business that attracts the best and the brightest. It is tempting to declare the industry a roaring success. But its purpose is to serve the needs of U.S. households and firms, and by this standard its performance has been mixed.

The sector’s growth has been beneficial for U.S. corporations, which enjoy ready access to the deepest capital markets in the world. Venture capital, for example, and the public equity markets that support it, has channeled money to innovative ideas that have transformed industries and generated new ones.

The rest of the economy, however, has not been well served by the financial sector’s boom. First, the shift from deposit-based banking to a market-based “shadow banking” system, without adequate regulatory adjustments, has left the financial system vulnerable to crisis. Second, trillions of dollars have been steered into residential real estate and away from more-­productive investments. Third, the cost of professional investment management is too high, which drains talent from other industries.

The financial sector could promote the health and competitiveness of the U.S. economy by increasing capital and liquidity requirements, reorienting the discussion around housing finance reform from keeping mortgage credit cheap to ensuring financial stability, and instituting measures that compel asset managers to compete on the true value of the services they provide.

Idea in Brief

Over the past three decades, the U.S. financial sector has grown much faster than the overall economy. Along the way, it has seen big gains in employment and compensation. But the financial sector exists to serve the needs of U.S. households and firms, and by this standard its performance has been mixed.

The sector’s growth has been beneficial to U.S. corporations, which enjoy ready access to the deepest capital markets in the world, but there are also problems. First, the financial system is less stable than it was 30 years ago. Second, the financial sector has steered trillions of dollars into residential real estate and away from other, more productive investments. Third, the cost of professional investment management is simply too high. Fixing these flaws will require changes in regulation but also private-sector discipline and innovation.

Photograph: FPG/Getty Images: U.S. Bureau of Engraving and Printing, 1929

The U.S. financial sector’s share of GDP grew from less than 5% in 1980 to more than 8% in 2007—the largest share in any advanced economy except Switzerland. With this growth came big increases in financial sector employment and compensation. The industry was transformed from a sleepy old boys’ club to a dynamic business that attracts the best and the brightest.

It is tempting, then, to declare the industry a roaring success. But the financial sector exists to serve the needs of U.S. households and firms, and by this standard its performance has been mixed. The sector’s growth has been beneficial for some, particularly U.S. corporations, which enjoy ready access to the deepest capital markets in the world. At the same time, the industry has evolved in several unhealthy ways, which have had negative consequences for the U.S. economy.

There are three main problems. First, the financial system is less stable than it was 30 years ago. The recent crisis was in part the consequence of a shift from traditional deposit-based banking to a market-based system, without adequate regulatory adjustments. Second, the financial sector—in combination with generous government subsidies—has steered trillions of dollars into residential real estate and away from other, more productive investments. Third, the cost of professional investment management, which has been growing as a share of GDP, is simply too high. Excessive investment fees have important implications not only for household savings but also for the allocation of the country’s talent: Finance will continue to attract the best and the brightest as long as the rewards are so high.

Successes

The key functions of a financial system are to facilitate household and corporate saving, to allocate those funds to their most productive use, to manage and distribute risk, and to facilitate payments. The financial sector is working well when it performs those functions at a low cost and makes the rest of the economy better off. Recent research has shown that economies with well-developed financial systems grow reliably faster than those in which finance plays a smaller role. In general, finance does serve a crucial economic purpose.

In the United States, the system appears to be working well for corporations, which enjoy easy access to debt and equity markets. The development in recent decades of institutional venture capital and private equity, along with the growth of professional money management, has helped improve the allocation of capital. Venture capital, in particular, has fostered a vibrant entrepreneurial sector that has transformed industries such as information technology and communications and has helped create new ones, such as online retailing and biotechnology. Venture-capital-backed entrepreneurs have also put pressure on existing firms to adapt their business models and to innovate.

Venture capital could not have thrived without stock market investors willing to purchase the shares of risky young firms. Their investments were made possible, in part, by the rise of professional money managers, who are in a better position than individual investors to assess the prospects of these newcomers. Ironically, 30 years ago a major concern was whether the increased emphasis on shareholder value would lead to an excessive focus on short-term profits. But the development of U.S. capital markets since then suggests the opposite: The percentage of firms that go public with negative earnings has jumped dramatically, demonstrating the willingness of the U.S. capital markets to bet on new ideas. This willingness is reflected in the growing amount of money the private sector has poured into R&D—an indication that the financial sector is steering capital toward long-run investments.

None of this is to say that venture capital and public equity markets have functioned perfectly. Venture capital has on average failed to deliver acceptable risk-adjusted returns for investors, and public equity markets seem to go through periods of euphoria and fear. But the same markets that overfunded internet and telecom start-ups during the late 1990s also identified and nurtured Google.

A Success Story: Financing R&D

Forty years ago, the U.S. government and private industry made roughly equal contributions to R&D.

Now private industry funds approximately four times as much R&D as the government—an indication that the financial sector is steering capital toward new ideas.

Private equity and hedge funds have at times played an important role in helping to unlock value trapped in large, underperforming conglomerates. They can work to align management and shareholder interests, fostering an environment in which well-run firms get capital and poorly run firms are shut down or acquired. This is healthy. However, private equity is not without problems. Like venture capital, it is subject to boom-and-bust cycles that undermine its value; transactions can often be motivated by tax considerations rather than true economic value creation; and the average returns to private equity investors have generally not been enough to compensate them for the risk they bear.

Failures—and How to Address Them

Despite the successes outlined above, the U.S. financial system has had difficulties managing and distributing risk, allocating capital, and facilitating low-cost savings. It has been prone to crisis, has diverted too much capital toward housing, and has been beset by what appear to be excessive investing costs.

Financial instability.

Until the recent crisis, the period after the Great Depression was one of unprecedented stability in the U.S. financial system—achieved in large part by regulatory oversight, deposit insurance, and the Federal Reserve’s “lender of last resort” capabilities. However, beginning in the 1980s, fundamental changes in the architecture of the financial system put it at risk. With lax oversight and a regulatory regime that was ill-suited to the new architecture, the system eventually came crashing down. Without extraordinary support from the U.S. government and the Federal Reserve, the financial crisis would have been even worse. Three years later, economic growth is anemic and unemployment remains high.

What changes made the financial system so vulnerable? As is now well known, part of the answer is the growth of securitization. This was fueled by significant flaws in the credit ratings process, which resulted in a breakdown in the quality of securitized loans. But securitization was part of a more fundamental transformation in which the critical functions of banking were provided by players other than traditional deposit-taking banks.

The growth of nonbank financial firms and investment vehicles—from Wall Street broker-dealers to Fannie Mae, Freddie Mac, insurance companies, hedge funds, and money market mutual funds—created a “shadow” banking system, so called because it serves the same basic functions as the traditional deposit-taking system. Like banks, financial organizations in this system collectively transform short-term savings into long-term loans to households and firms—what economists call maturity transformation.

A compelling economic logic underlies shadow banking: Risks can be shared across the system instead of concentrated in individual banks. But the financial crisis revealed at least three significant weaknesses of shadow banking and the broader financial system.

A compelling logic underlies shadow banking: Risks can be shared across the system instead of concentrated in individual banks.

First, the amount of capital that regulators required the shadow banking system to hold against securitized credit risk was lower than the amount banks were required to hold. As a result, financial activity shifted from banks to shadow banks in a form of regulatory arbitrage. And when low-quality securitized loans began to go bad, there was insufficient capital to absorb the losses.

Second, the entities involved in shadow banking were tightly connected to one another and to the traditional banking sector. Those links created considerable risks that were poorly understood before the crisis.

Third, the shadow banking system turned out to be vulnerable to the same kind of bank runs that plagued traditional banks prior to the establishment of deposit insurance. Creditors could run on a moment’s notice by, for example, refusing to roll over short-term loans. Without the supports offered to the traditional banking sector, even relatively small losses could bring shadow banking to a standstill.

We face many challenges in stabilizing the financial system. Significantly increasing capital requirements, which regulators have agreed to do, would go a long way in that regard. Limiting the extent to which financial firms can fund long-term assets with short-term liabilities—thereby decreasing the risk of bank runs—would also help protect the system. And placing stronger safeguards on the largest financial institutions would be an important measure to promote stability. Whatever is done, regulatory treatment should be consistent across the traditional banking and shadow banking sectors. Making this work will require approaches beyond those in the standard regulatory tool kit.

Top executives of financial services firms often say that nobody could have predicted the magnitude of the crisis and that nobody will be able to predict the source of the next one. It’s impossible to know if that is true, but it strengthens the case for increased capital and liquidity requirements.

Housing finance.

The United States has been an outlier in its support of homeownership, through both government policy and private-sector activities. Fannie Mae, Freddie Mac, and the Federal Housing Administration implicitly or explicitly guaranteed more than half of all outstanding home mortgages in the years before the financial crisis (and the percentage has only gone up since). The government also subsidizes homeownership through the mortgage-interest deduction—a benefit extended by only a handful of countries. And the private sector was an eager and increasingly careless mortgage lender. The subsequent crisis was the culmination of decades of rising mortgage-credit availability.

The excess allocation of capital toward housing diverted resources from potentially more productive uses. Moreover, subsidies and easy credit drove up the demand for residential real estate, most likely increasing prices in coastal cities with limited housing supply and leading to overbuilding in other areas. When home values appreciated, households borrowed against their equity to finance consumption. Rising house prices put a damper on homeownership rates, reduced household savings rates, and left households vulnerable to economic adversity. The current debt burden on underwater homeowners is stifling U.S. economic recovery.

The Rise of Finance

The leading proposals for housing finance reform—supported by a coalition of the financial services industry, the real estate industry, and consumer advocates—focus on keeping mortgage credit cheap and available and call for government to play a critical role in achieving that goal. We think this focus is misplaced. The long-term goal of housing finance reform should be to promote financial stability and the proper allocation of capital. In their book This Time Is Different, Carmen Reinhart of the Peterson Institute for International Economics and Kenneth Rogoff of Harvard University show that real-estate-related crises, which often have their roots in an excess supply of credit, are common and do lasting damage to the banking sector and economic growth. Housing policy should therefore seek to reduce volatility in the credit supply and protect the financial system from shocks to the housing sector. [insert ref=”callout-02″]

How can this goal be achieved while weaning the housing market off government subsidies? The industry should focus on designing securities that deliver the fundamental promise of securitization—enhanced liquidity and diversification of risk—and not on those that arbitrage gaps in regulation. Once the government steps back from guaranteeing most new mortgage credit, private securitization of mortgage credit can and should return. As we discussed above, regulations must recognize that securitized mortgage credit performs some of the same functions as deposit-based banking and is prone to some of the same risks. The details of how to regulate housing finance remain to be worked out, but reorienting the discussion to ensuring financial stability will go a long way toward better serving U.S. households and economic competitiveness.

Investment costs.

The asset management and securities industry grew from 0.4% of GDP in 1980 to 1.9% in 2006. This reflects growth in financial assets and in the share of those assets that are managed professionally. It also reflects the industry’s high fees.

The sector’s ability to maintain those fees despite fierce competition to manage assets is partly due to consumers’ lack of financial sophistication. Fees are assessed on the basis of a fund’s overall performance rather than on relative risk-adjusted performance. This means that if the market as a whole rises, equity managers garner higher fees—even if a passive index fund would have done just as well. Decades of studies have produced little evidence that equity fund managers outperform market indexes with similar risk, even before fees.

Mutual fund fees have been falling over time, but high-fee vehicles such as hedge funds have been gaining market share. As a result, the total fee for equity management as a percentage of market capitalization has remained approximately constant, at 0.8% of assets under management, according to Dartmouth’s Kenneth French. In their efforts to beat the market, money managers make decisions and dig up information that leads to more accurate pricing of stocks. Is 0.8% a reasonable rate for society to pay for that service? It seems high in light of the technological progress of the past several years: Despite increasing computer speed and advances in information technology, the financial sector is about as productive, per unit of managed funds, as it was 30 years ago.

Equity management firms and their employees have profited handsomely from the run-up in stock values since 1980. In fact, we estimate that a big part of the increase in the financial sector’s share of GDP can be explained simply by the increase in stock prices from 1980 to 2006. There is no reason to believe that high-priced stocks are more costly to manage. Many investors do not appreciate how quickly fees add up: Owing to compounding, overpayments of 80 basis points per year for 30 years equals about 21% of current wealth.

High investment fees affect U.S. competitiveness chiefly by distorting the allocation of talent. Among employed 2008 graduates of Harvard College, 28% went into financial services, compared with about 6% from 1969 to 1973. The industry’s attraction is not difficult to understand: According to a study by Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, in 1980 a financial services employee typically earned about the same wages as his counterpart in other industries; by 2006 he was earning 70% more. The channeling of talent to finance can be justified if the high wages and profits reflect value added to the rest of the economy. But if investment fees are too high, then finance is inefficiently draining talent from other industries, hampering overall productivity growth. Imagine if Bill Gates or Steve Jobs had left college to start a hedge fund.

The Allocation of Talent

Among employed 2008 graduates of Harvard College, 28% went into financial services, compared with about 6% from 1969 to 1973.

In 1980 a financial services employee typically earned about the same wages as his counterpart in other industries; by 2006 he was earning 70% more.

One area in which costs have come down is trading in equity markets, where commissions and bid-ask spreads are much lower than they were 30 years ago. But institutional investors, corporations, and financial firms pay high costs to trade in many over-the-counter markets for corporate bonds and derivatives, where prices are quoted by individual brokers and getting information can be expensive. This gives brokers a degree of pricing power, allowing them to command higher spreads from trading. The problem is transparency. Studies of the corporate and municipal bond markets have shown that market opacity increases trading costs. Price reporting systems for corporate bonds and exchanges and clearinghouses for derivatives should therefore lower costs.

Investment costs are unlikely to fall overnight. Nevertheless, they can be reduced by making fees more visible so that financial firms can better compete on them. For most households, asset management should be a utility—low cost and reliable. But in retirement accounts, for example, management fees are sometimes hard to identify. We should also demand accountability and transparency from companies that select retirement funds for their employees. It should not be acceptable, for instance, to offer employees an index fund with annual fees of 1% when an identical product is available at one-fifth of the cost. The broad principle underlying both proposals is that asset managers should compete on the true value of the services they provide.

Pension funds and endowments can be an important voice in this discussion. These investors pay low fees for the active management of public equities but very high ones for private equity, venture capital, and hedge funds. The evidence suggests that those vehicles have, on the whole, delivered only modest risk-adjusted returns to investors. Active investing is difficult, and talented managers should be paid for their performance. But investors should be paid for skill, not luck.In a recent competitiveness survey of HBS alumni, respondents listed the capital markets as an enduring strength of the U.S. economy. Yet aspects of the financial sector have distorted the allocation of talent and capital and have left the economy vulnerable to crisis. In the end, the financial sector should be judged not on its profitability and size but on how well it promotes a healthy, more competitive economy over the long term.

A version of this article appeared in the March 2012 issue of Harvard Business Review.

Robin Greenwood is an associate professor of business administration and David S. Scharfstein is the Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School.

David S. Scharfstein is the Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School.